Cash Reigns Supreme

Published June 17, 2008

There are two basic methods for keeping track of law firm financial performance: accrual versus cash accounting. Accrual records reflect income irrespective of whether cash has been collected. In other words, accrual accounting reflects billings, work in progress (completed but not yet billed) and accounts receivable (work billed but not yet collected). Cash accounting, on the other hand, reflects only collections, never billings or work in progress. Almost all small law firms operate on a cash basis, accounting for cash as it comes in and goes out. Larger law firms maintain both cash and accrual records.

I have seen it suggested that only accrual accounting tells an accurate picture of a law firm’s financial position. Yet, one can find many businesses that have good accrual financial statements but fail because they lack cash flow to sustain their business. The reverse is true. Businesses can show losses in the accrual system but have great cash flow—they collect their sales and receivables very quickly and survive for quite a long time.

Profits are essential, but cash is and has always been the key ingredient for successful businesses and law practices. And the foundation of having cash in hand is effective collection efforts. Cash collected is far more important than hours billed. The formal term for this is “realization,” the amount of time actually billed and collected. Realization is sometimes discussed in two levels: Percent of billable or booked hours billed (billed to billable ratio) and percent of billed work collected (collected to billed ratio). The goal is to bill for work you do (no write-downs) and to collect what you bill (no write-offs). An overall realization ratio of less than 80 to 85% is a recipe for trouble.

Several years ago, when the 300-lawyer global law firm of Altheimer & Gray was forced to file for bankruptcy, a very important fact got little attention: the firm had $30 million in outstanding accounts receivable. Had Altheimer & Gray been more diligent and aggressive in collecting the money it was owed, it might have remained alive. The importance of collections could not be more obvious, for the largest law firms and for sole practitioners alike.

According to one survey, it takes between 120 and 150 days—as much as five months—for the average law firm to turn billable hours into cash. That means that a typical small firm should have funds sufficient to operate for at least six months without new billings coming in. But no firm should ever let things reach that point—and the firm that emphasizes cash flow will not have to worry about it.

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Audience type: Administrators, Associates, Large Law Firms, Small Law Firms, Sole Practitioners